Retirement plans like 401(k)s let employees contribute portions of their hard-earned wages to investment accounts that are managed by financial services groups associated with employers. They are an important part of many Americans' retirement strategies. The IRS explains that people who take distributions before they turn 59½ can face stiff tax penalties and early withdrawal fees, but using your 401(k) to buy a car may be the right decision under certain circumstances. You may also be exempt from some of the typical penalties for withdrawal, depending on your circumstances.
Using 401(k) to Buy a Car
Retirement plans like 401(k)s are a great way to build up investment portfolios, and as long as the money stays invested, all of your contributions are tax-deductible. Financial advisors do not recommend withdrawing the money before age 59½ if at all possible, because of the significant income taxes and fees that are incurred.
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Unless you are facing a financial hardship, using your 401(k) savings before the age stipulated is not typically the best option; the associated penalties can render your investment gains much less effective. It's ideal to look for other ways to finance a car. In addition, it's important to note that every employer that offers 401(k) plans has different rules that apply to loans and withdrawals.
If the plan does allow for loans, you will need to sign a loan agreement that includes terms like the length of the loan, interest rate, principal amount and fees that will be charged. According to FINRA, the IRS sets limits on the maximum amount that can be borrowed, which is either $50,000 or half the amount that you are vested. The usual term for a 401(k) car loan is five years, but it can be shorter; 401(k) home loan can have much longer repayment terms.
401(k) Hardship Withdrawal to Buy a Car
The IRS posts that some 401(k) plans allow owners to receive hardship distributions because of immediate, heavy financial needs that have to be satisfied. If your plan allows for hardship distributions, it will have objective, nondiscriminatory standards that will determine how dire the need actually is. They will make their decision based on relevant facts and circumstances. Luxury purchases like boats will certainly not qualify.
Qualifying circumstances might be the need to purchase a home, medical care expenses, funeral expenses, tuition or damages to the employee's principal residence. Requesting a 401(k) hardship withdrawal to buy a car will likely result in a denial, but you may be approved depending on your situation.
Additional Options for Car Purchasing
You can always withdraw the money without the hardship approval, but again, you will be paying the extra fees and taxes. When 401(k) plans permit hardship distributions, they will also specify what information is required to show proof of a hardship. They may have to inquire into the employee's financial status, or the employer may be able to verify some information through the employer's insurance.
A loan can be a better option, but only if you will be able to repay it within the specified time frame with a reasonable interest rate. Taking early withdrawals, even if there are no fees, will take away funds for your retirement which could hurt you in later years. You will need to reach out to the 401(k) provider to see what their rules are, but understand that early 401(k) withdrawals should only be made in case of emergencies.
Consider also: Acceptable Reasons to Cash Out a 401(k)